3.

MONEY MARKETS

Mini contents  The purpose of money markets

 Money markets segments and participants
 Money market instruments
 Money market rates and yields

3.1. Money market purpose and structure

3.1.1. The role of money markets
The purpose of money markets is facilitate the transfer of short-term funds from agents
with excess funds (corporations, financial institutions, individuals, government) to those
market participants who lack funds for short-term needs.
They play central role in the country’s financial system, by influencing it through the
country’s monetary authority.
For financial institutions and to some extent to other non-financial companies money
markets allow for executing such functions as:
 Fund raising;
 Cash management;
 Risk management;
 Speculation or position financing;
 Signalling;
 Providing access to information on prices.
Money markets are wholesale markets with very large amounts of transactions, e.g. with
transactions from 500 million Euro to 1 billion Euro or even larger ones. This is the most
active financial market in terms of volumes of trading.
From the start of emergence the traditional money markets performed the role of
monetary policy. In order to influence the supply side, governments have employed
methods of direct regulation and control of the savings and investment behaviour of
individuals and companies. However due to fast technological advances,
internationalization and liberalization of financial markets, possibilities to carry out policy
objectives through such measures have diminished. Current policy through market-
oriented measures is aimed primarily at demand side. Thus money markets serve the
interface between execution of monetary policy and the national economies
Another role of domestic money markets is to serve public policy objectives, i.e.
financing public sector deficits and managing the accumulated government deficits.
Government public debt policy is an important determinant of the money markets
operations, since government debt typically forms a key part of the country’s money
markets (as well as debt markets). The scope and measures of monetary policy are also
linked to the government’s budget and fiscal policies. Thus the country’s money market

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shifts are dependant upon the goals of national public policy and tools used to reach these
goals.
Changes in the role and structure of money markets were also influenced by
financial deregulation, which evolved as a result of recognition that excessive controls are
not compatible with efficient resource allocation, with solid and balanced growth of
economies. Money markets went through passive adaptation as well as through active
influence from the side of governments and monetary authorities.
Finally, money markets were influenced by such international dimensions as
increasing capital mobility, changing exchange rate arrangements, diminishing monetary
policy autonomy. The shifts in European domestic money markets were made by the
European integration process, emergence and development of European monetary union.

3.1.2. Money market segments

In a broad sense, money market consists of the market for short-term funds, usually with
maturity up to one year. It can be divided into several major segments:
Interbank market, where banks and non-deposit financial institutions settle
contracts with each other and with central bank, involving temporary liquidity surpluses
and deficits.
Primary market, which is absorbing the issues and enabling borrowers to raise
new funds.
Secondary market for different short-term securities, which redistributes the
ownership, ensures liquidity, and as a result, increases the supply of lending and reduces
its price.
Derivatives market – market for financial contracts whose values are derived
from the underlying money market instruments.
Interbank market is defined mainly in terms of participants, while other markets are
defined in terms of instruments issued and traded. Therefore there is a considerable
overlap between these segments. Interbank market is referred mainly as the market for
very short deposits and loans, e.g. overnight or up to two weeks. Nearly all types of money
market instruments can be traded in interbank market.
Key money market segments by instruments are provided in Figure 6

Figure 6. Key money market instruments

The money-market instruments are often grouped in the following way:

 Treasury bills and other short-term government securities (up to one year);

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  Interbank loans, deposits and other bank liabilities;
 Repurchase agreements and similar collateralized short-term loans;
 Commercial papers, issued by non-deposit entities (non-finance companies, finance
companies, local government, etc. ;
 Certificates of deposit;
 Eurocurrency instruments;
 Interest rate and currency derivative instruments.
All these instruments have slightly different characteristics, fulfilling the demand of
investors and borrowers for diversification in terms of risk, rate of return, maturity and
liquidity, and also diversification in terms of sources of financing and means of payment.
Many investors regard individual money market instruments as close substitutes, thus
changes in all money market interest rates are highly correlated.
Major characteristics of money market instruments are:
 short-term nature;
 low risk;
 high liquidity (in general);
 close to money.
Money markets consist of tradable instruments as well as non-tradable instruments.
Traditional money markets instruments, which included mostly dealing of market
participants with central bank, have decreased their importance during the recent period,
followed by an increasing trend to finance short-term needs by issuing new types of
securities such as REPOs, commercial papers or certificates of deposit. The arguments
behind the trend are the following:
1. An observed steady shift to off-balance sheet instruments, as a reaction to
introduction of capital risk management rules for internationally operating banks in
the recommendations of Basel II Accord and EU Directives on banking.
2. Advantages provided to high-rated market participants, allowing to diversify
borrowing sources, to cut the costs, to reduce the borrowers’ dependence on
banking sector lending and its limitations.
In terms of risk two specific money-market segments are:
 unsecured debt instruments markets (e.g. deposits with various maturities, ranging
from overnight to one year);
 secured debt instruments markets (e.g. REPOs) with maturities also ranging from
overnight to one year.
Differences in amount of risk are characteristic to the secured and the unsecured
segments of the money markets. Credit risk is minimized by limiting access to high-quality
counter-parties. When providing unsecured interbank deposits, a bank transfers funds to
another bank for a specified period of time during which it assumes full counterparty credit
risk. In the secured REPO markets, this counterparty credit risk is mitigated as the bank
that provides liquidity receives collateral (e.g., bonds) in return.
Money markets structures differ across the countries, depending upon regulatory and
legislative frameworks, factors that have supported or limited the development of such

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national markets. The influence of business culture and traditions, industrial structures
have played an important role also.
Economic significance of money markets is predetermined by its size, level of
development of infrastructure, efficiency. Growth of government securities issues, their
costs considerations, favourable taxation policies have become additional factors boosting
some of the country’s money markets.

3.1.3. Money market participants

Money market participants include mainly credit institutions and other financial
intermediaries, governments, as well as individuals (households).
Ultimate lenders in the money markets are households and companies with a financial
surplus which they want to lend, while ultimate borrowers are companies and government
with a financial deficit which need to borrow. Ultimate lenders and borrowers usually do
not participate directly in the markets. As a rule they deal through an intermediary, who
performs functions of broker, dealer or investment banker.
Important role is played by government, which issue money market securities and use the
proceeds to finance state budget deficits. The government debt is often refinanced by
issuing new securities to pay off old debt, which matures. Thus it manages to finance long-
term needs through money market securities with short-term maturities.
Central bank employs money markets to execute monetary policy. Through monetary
intervention means and by fixing the terms at which banks are provided with money,
central banks ensure economy’s supply with liquidity.
Credit institutions (i.e., banks) account for the largest share of the money market. They
issue money market securities to finance loans to households and corporations, thus
supporting household purchases and investments of corporations. Besides, these
institutions rely on the money market for the management of their short-term liquidity
positions and for the fulfilment of their minimum reserve requirements.
Other important market participants are other financial intermediaries, such as money
market funds, investment funds other than money-market funds, insurance companies and
pension funds.
Large non-financial corporations issue money market securities and use the proceeds to
support their current operations or to expand their activities through investments.
In general issuance of money market securities allow market participants to increase their
expenditures and finance economic growth.
Money market securities are purchased mainly by corporations, financial intermediaries
and government that have funds available for a short-term period. . Individuals (or
households) play a limited role in the market by investing indirectly through money
market funds. Apart from transactions with the central bank, money-market participants
trade with each other to take positions dependant upon their short-term interest rate
expectations, to finance their securities trading portfolios (bonds, shares, etc.), to hedge
their longer-term positions with short-term contracts, and to reduce individual liquidity
imbalances

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 3.2. Money market instruments
3.2.1. Treasury bills and other government securities
Treasury bills are short-term money market instruments issued by government and backed
by it. Therefore market participant view these government securities as having little or
even no risk. The interest rates on Treasury securities serve as benchmark default-free
interest rates. A typical life to maturity of the securities is from four weeks to 12 months.
As they do not have a specified coupon, they are in effect zero-coupon instruments and are
issued at a discount to their par or nominal value, at which price they are redeemed. Any
new issue with the same maturity date as an existing issue is regarded as a new tranche of
the existing security.
Question What are key characteristics of Treasury bills?

Treasury bills are typically issued at only certain maturities dependant upon the
government budget deficit financing requirements. Budget deficits create a challenge for
the government. Large volumes of Treasury securities have to be sold each year to cover
annual deficit, as well as the maturing Treasury securities, that were issued in the past. The
mix of Treasury offerings determines the maturity structure of the government’s debt.
Primary market. The securities are issued via a regularly scheduled auction process.
Upon the Treasury’s announcement of the size of upcoming auction, tenders or sealed bids
are being solicited.
Concept A tender is a sealed bid.

Bidders are submitting two types of bids: competitive and non-competitive. A competitive
bidder specifies both the amount of the security that the bidder wants to buy, as well as
the price that the bidder wants to pay. The price is set in terms of yield. The price of the
securities in the auction is set based on the prices offered in competitive bids, taking the
average of all accepted competitive prices. Not all competitive bids that are tendered are
accepted. Typically the longer the maturity, the greater would be the percentage of
accepted bids. The percentage of accepted bids is determined by the size of the issue as
compared to the amount of bids tendered. Competitive bidders are the largest financial
institutions that generally purchase largest amounts of Treasury securities. In general 80-
90% Treasury securities are sold to them.
A non- competitive bidder specifies only the amount of the security that the bidder wants
to buy, without providing the price, and automatically pay the defined price. Non-
competitive bidders are retail customers, who purchase low volumes of the issues, and are
not enough sophisticated to submit a bid price. Limits on each non-competitive bid can be
set. Direct purchases of Treasury securities by individuals are limited in many countries. In
such cases they use the services of dealers.
The Figure 7 illustrates the results of sealed bid (tender) auction. The Treasury will accept
the competitive bids with the highest price and lowest interest rates, and will reject other
bids.
Depending upon the existing regulation in a specific country treasury security auctions can
be organized and held at the central bank or stock exchanges.
There are two auction forms:
 Uniform price auction, when all bidders pay the same price;

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  Discriminatory price auction, in which each bidder pays the bid price.

Price Supply curve

Accepted
bids

Rejected
bids

Price of
lowest
accepte
d bid Demand
curve

Amount of
bonds

Figure 7. Prices in a sealed-bid auction

The procedure of the discriminatory price auction one is more sophisticated. At first, all
the non-competitive bids are totaled, and their sum is subtracted from the total issue
amount. This way all non-competitive bids are fulfilled. The price, which non-competitive
bidders are going to pay, is determined taking into account the results of the competitive
part of the auction.
Concept Uniform price auction is an auction, when all bidders pay
the same price.

Concept Discriminatory price auction is an auction, in which each

bidder pays the bid price.
Further on, all competitive tenders are ranked in order of the bid yield. In order to
minimize the governments borrowing costs, the lowest competitive bid is accepted first.
As a result, the highest bid prices are accepted until the issue is sold out fully. The lowest
rejected bid yield (or the highest accepted bid yield) is called stop yield. The
corresponding price is called the stop-out price.
During such a Treasury auction, each competitive bidder pays the price for the securities,
which is determined by the yield that was bid. The average yield is the average of all
accepted competitive bids, weighted by the amounts allocated at each yield. All non-
competitive bidders pay the average yield.

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The discriminatory auction is characterized by
 a tail – the difference between the stop yield and the average yield;
 a cover – the ratio between the total amount competitive and non-competitive bids
tendered and the total issue (i.e. the total amount of accepted bids). .
A large cover indicates active market participation in an auction. Average cover can be
evaluated in terms of a difference between maximum and minimum accepted bid yields (in
basis points) A small tail shows that most competitive bidders provide similar evaluation
of Treasury security issue, and thus pay nearly the same price for it. The larger the cover
and the smaller the tail, the more efficient is the Treasury auction.
Concept Basis point is a very fine measure of interest rates, equal to
one hundredth of one percentage point.

In a discriminatory price auction the bidder’s price is determined by his own tender. A low
bid, i.e. low yield and high offered price, increases the bidder’s chance of his bid to be
accepted. However, this can lead to the possibility of the winner’s curse. In such a case
the low bidder’s tender is accepted, but he pays a price that is higher than of others lower
priced (or higher yield) bids. Therefore competitive bidders may be reluctant to submit low
bids, because this will oblige them to pay high prices for newly issued securities. This is a
problem of discriminatory price auction.
Concept Winner’s curse is the case, when the low bidder wins
acceptance of the tender, but pays a price, which is higher
than that of other lower bidders.
A uniform price auction (or a Dutch auction) does not have a problem of this kind. All the
procedures of the auction except for the last one are the same as in the discriminatory price
auction. Each accepted bid pays the price of the lowest accepted bid.
As a result, uniform price auction becomes more expensive to the Treasury and it receives
lower revenue. Besides, the average bidder may bid a higher price, shifting demand curve
to right with the possibility offsetting the negative effect to the Treasury (see Figure 8).
Price Supply curve
Accepted bids Rejected bids

Single-price
Price in single- demand
price auction
Discriminatory
Lowest accepted demand
discriminatory bid
Amount of
bonds

Figure 8. Impact of single-price auction upon demand curve

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Uniform price auction is considered fairer because all competitive bidders pay the same
price. This may encourage greater participation in the auction, and finally increase the
auction’s cover indicator. Competitive bidders are not afraid to submit too low bids,
because they will not be paying the price they bid. Conversely, the lower they will bid, the
higher likelihood is that their bid will be accepted. As a result, bidders tend to reduce their
bids, thereby lowering the average yield on the entire issue. Such changes in bidder
behaviour may offset the direct effect of higher issuer’s interest costs in the uniform price
auction.
While evaluating the effectiveness of the Treasury auction method, there is a concern, that
competitive as well as non-competitive bidders can be neglected, while few large financial
institutions may be favoured. This can cause decline in auction participation, undermining
the Treasury’s abilities to place large amounts of securities. On the other hand, since
bidders do not pay their tendered prices, the uniform price auction may be more subject to
manipulation or collusion by informed bidders.
Question What is the role of competitive and non-competitive bidders
in the Treasury securities auction?

Secondary market. Typically the Treasury securities have an active and liquid secondary
market. The most actively traded issues, which are usually the ones sold through an
auction most recently, are called on-the-run issues. They have narrower bid-ask spreads
than older, off-the-run issues. The role of brokers and dealers is performed by financial
institutions. As a rule, competitive bidders can submit more than one bid to each auction,
with different prices and quantities on each tender. However, in well developed markets
limitations are being placed to the amount of securities in each auction allocated to a
particular single bidder. The aim of such a rule is to prevent market from influence of a
single bidder, and thus squeezing other financial institutions with their own customers.
Question What is the role of competitive and non-competitive bidders
in the Treasury securities auction?

The text then can follow (starting with the style of the first paragraph). Then, we can have
some readings or an example. It can be but in the same format as the Concept/Check
Question.
Price of a Treasury bill is the price that an investor will pay for a particular maturity
Treasury security, depending upon the investor’s required return on it. The price is
determined as the present value of the future cash flows to be received. Since the Treasury
bill does not generate interest payments, the value of it is the present value of par value.
Therefore, since the Treasury bill does not pay interest, investors will pay a price for a
one-year security that will ensure that the amount they receive one year later will generate
the desired return.
Example Assume investor requires a 5 percent annualized return on a
one-year Treasury bill with a 100000Euro par value. He will
be willing to pay the price
P = 100000 Euro / 1,05 = 95238 Euro
If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result
in a lower price to be paid today.

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In case the maturity of Treasury bill is shorter than one year, then the annualized return
will be reduced by the fraction of the year, during which the investment is made. The
simplified calculations are provided in the example below.
Example Assume investor requires a 5 percent annualized return on a 6
month Treasury bill with a 100000 Euro par value. The price
of the security will be
P = 100000 Euro / ( 1 + 0,05 / 2) =
= 100000 Euro / ( 1 + 0,025) = 97560,9 Euro
If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result
in a lower price to be paid today.
The price of the Treasury bill calculated on discount rate basis is:
P = PAR x (1- (d x n / 360))
where d is the yield or rate of discount, PAR is par or maturity value and n is the number
of days of the investment (holding period).
Example Assume investor requires an 8 percent annualized return on a
91-day Treasury bill with a 100000 Euro par value. The price
of the security will be
P = 100000 Euro x ( 1 – (0,08 x 91/ 360) =
= 100000 Euro x ( 1 – 0,02 ) = 98000 Euro
If investor requires a return higher than 5 percent, he will
discount the par value at a higher return rate. This will result
in a lower price to be paid today.
Yield of a Treasury bill is determined taking into account the difference between the
selling price and the purchase price. Since Treasury bills do not offer coupon payments,
the yield the investor will receive if he purchases the security and holds it until maturity
will be equal to the return based on difference between par value and the purchase price.
The annualized yield on Treasury bill is calculated in the following way:
y = (PAR - P) / P x (365/n)
where d is the yield, PAR – par value, P - purchase price of the Treasury bill and n is the
number of days of the investment (holding period).
Example Assume investor requires pays 98000 Euro for a 91-day
Treasury bill with a 100000 Euro par value. The annualized
yield of the security will be
y = (100000 – 98000) / 98000 ) x ( 365 / 91 ) =
= 0,02 x 4,01 = 0,0802 or 8,02 %.
If the Treasury bill is sold prior to maturity, the return is calculated on the basis of
difference between the price for which the bill was sold in the secondary market and the
purchase price.
The annualized yield on Treasury bill is calculated in the following way:
y = (SP - P) / P x (365/n)

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where d is the yield, SP – selling price, P - purchase price of the Treasury bill and n is the
number of days of the investment (holding period).
In some countries (e.g. US) Treasury bills are quoted on a discount rate (or referred to as
Treasury bill rate) basis. The Treasury bill discount rate represents the percent discount of
the purchase price from par value of a new issue of a Treasury bill. It is determined in the
following way:
d = (PAR - P) / PAR x (360/n)
where d is the yield, PAR – par value, P - purchase price of the Treasury bill and n is the
number of days of the investment (holding period).
In such a case the year is assumed having 360 days, and the number of days of the
investment can be actual or an assumed convention. If a newly issued Treasury bill is held
until maturity, then its yield is always greater than rate of discount. The difference is due
to price or value used in denominator, since purchase price is always lower than par value.
Besides, the yield is always calculated on 365 day during a year basis.

3.2.2. The interbank market loans

Interbank market is a market through which banks lend to each other.
Commercial banks are required to keep reserves on deposits within central bank. Banks
with reserves in excess of required reserves can lend these funds to other banks.
Traditionally this formed the basis of the interbank market operations. However, currently
these operations involve lending any funds in reserve accounts at a central bank.
Concept Interbank market is a market which involves bank
borrowing and lending of any funds in reserve accounts at the
central bank.
In US the interbank market is the federal funds market, which involves the borrowing and
lending any funds in reserve accounts at the Federal Reserve Bank (FED).
The major characteristics of the interbank markets are:
 The transfer of immediately available funds;
 Short time horizons;
 Unsecured transfers.
Individual banks have a possibility to invest (lend) surplus funds and have a source of
borrowing when their reserves are low, thus they manage their reserve position and fund
their assets portfolio by trading at the interbank market. This is a wholesale market with
deals usually in large denominations. It is used by all types of banks, involved in loans for
very short periods, from overnight to fourteen days mostly. Then bank borrows in the
interbank market, it is said to be a funds buyer. When bank lends immediately available
reserve accounts, it is said to be a seller. Most banks simultaneously buy and sell funds all
the time. By acting as dealers they make markets for funds by announcing willingness to
buy or to sell at the current competitive interbank rate.
The interbank interest rates and interest rates in the traditional market are interconnected.
If banks are short of liquidity they will lend less to both markets and will cause interest
rates to rise. When Central bank provides funds to the discount market, less attractive
terms are offered by banks. Thus they may choose other markets to invest and will cause
the drop in interest rates.

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Interbank rates are generally slightly higher and more volatile than interest rates in the
traditional market. In periods of great shortage of liquidity, the needs of banks which do
not have sufficient funds to meet the central bank requirements drive up the overnight rates
significantly.
To keep up the speed of the transfer and the costs of transfer down, the interbank market
transfers are unsecured, i.e. not backed by any collateral and have no protection against
default by the borrowing bank.
Credit risk in the interbank market is controlled through the interbank rate, which is truly
competitive, quoted market rate. It is determined entirely by the supply and demand of
banks for funds. Since the market is a closed interbank system, the aggregate value of all
buy orders (demand for funds) should be equal to the aggregate value of all sell orders
(supply of funds). If the demand for fund purchases increases, it drives up the interbank
interest rate.
Question How is interbank interest rate determined?

Participants in the interbank market typically undertake two types of transactions:

 reserve management transactions;
 portfolio management transactions.
Bank reserve management transactions allow complying with contemporaneous bank
reserve requirements.
Through portfolio management transactions banks use interbank market to finance their
assets’ portfolio. These are encouraged by the interbank market liquidity and flexibility.
With time horizons as short as overnight, the transactions can be made rapidly at low
transaction costs.
Unlike other instruments ‘traded’ in the money markets, interbank deposits are not
negotiable i.e. do not have a secondary market. A lending bank which wishes to retrieve its
funds simply withdraws the deposit from the bank to which it was lent. Thus, In this case,
the distinction between primary and secondary markets is irrelevant.
Question How has the interbank interest rate volatility changed over
the recent years? What is the major cause of this change?

3.2.3. Commercial papers

Commercial paper (CP) is a short-term debt instrument issued only by large, well
known, creditworthy companies and is typically unsecured. The aim of its issuance is to
provide liquidity or finance company’s investments, e.g. in inventory and accounts
receivable.
The major issuers of commercial papers are financial institutions, such as finance
companies, bank holding companies, insurance companies. Financial companies tend to
use CPs as a regular source of finance. Non-financial companies tend to issue CPs on an
irregular basis to meet special financing needs.
Thus commercial paper is a form of short-term borrowing. Its initial maturity is usually
between seven and forty-five days. In US, the advantage of issuing CPs with maturities
less than nine months is that they do not have to register with the Securities Exchange

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Commission (SEC) as a public offering. This reduces the costs of registration with SEC
and avoids delays related to the registration process.
CPs can be sold directly by the issuer, or may be sold to dealers who charge a placement
fee (e.g. 1/8 percent). Since issues of CPs are heterogeneous in terms of issuers, amounts,
maturity dates, there is no active secondary market for commercial papers. However,
dealers may repurchase CPs for a fee.
Question What is the role of financial institutions in the commercial
paper market?

The price of CP is calculated in the following way:

P = PAR x (1- (d x n / 360))
where d is the yield or rate of discount, PAR is par or maturity value and n is the number
of days of the investment (holding period).
CP is sold at a discount to its maturity value, thus it is the other money market instrument
whose return is expressed on a discount basis.
Example A 30 day CP with 10 million Euro par value yields 4,75%.
The price of this CP currently offering is equal to
P = 10,0 million Euro x (1- (0,0475 x 30 / 360)) =
= 10,0 million Euro x (1- 0,003) = 9,97 million Euro
The yield on CP is calculated in the following way:
d = (PAR - P) / PAR x (360/n)
where d is the yield or rate of discount, PAR – par value, P - initial price of the CP and n is
the number of days of the investment (holding period).
Example Investor has purchased a 30 day CP with a par value of 1
million Euro for a price of 990 000 Euro. What is the yield of
this CP investment?
d = (1 mil Euro - 990 000 Euro) / 1 mil Euro x (360/30) =
= 0,01 x 12 = 0,12 or 12 %.
Commercial paper is normally unsecured against any specific assets and firms wishing to
use the commercial paper market will usually seek a credit rating from one or other of the
credit rating agencies. A high rating will mean that such paper can be issued at a smaller
discount, often amounting to the equivalent of 1 per cent. Although commercial paper is
unsecured, typically it is backed by a line of credit at a commercial bank.
As a source of finance, commercial paper serves a similar purpose to commercial bills
(and is priced in the same way). Thus, in countries with a highly developed discount, or
bills, market, the market for commercial paper is relatively small (e.g. UK). However,
when the commercial bill market is less developed, the commercial paper market is very
large (e.g. France and US). The main difference between commercial papers and
commercial bills lies in the manner of their creation. A firm borrows via a commercial bill
when it agrees to ‘accept’ a bill which is ‘drawn’ by a creditor. The bill originates with the
lender. A firm borrows via commercial paper when it issues the paper itself.
Question What are the substitutes for commercial paper?

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 3.2.4. Certificates of deposit
Certificate of deposit (CD) states that a deposit has been made with a bank for a fixed
period of time, at the end of which it will be repaid with interest.
Thus it is, in effect, a receipt for a time deposit and explains why CDs appear in definitions
of the money supply such as M4. It is not the certificate as such that is included, but the
underlying deposit, which is a time deposit like other time deposits.
An institution is said to ‘issue’ a CD when it accepts a deposit and to ‘hold’ a CD when it
itself makes a deposit or buys a certificate in the secondary market. From an institution’s
point of view, therefore, issued CDs are liabilities; held CDs are assets.
The advantage to the depositor is that the certificate can be tradable. Thus though the
deposit is made for a fixed period, he depositor can use funds earlier by selling the
certificate to a third party at a price which will reflect the period to maturity and the
current level of interest rates.
The advantage to the bank is that it has the use of a deposit for a fixed period but,
because of the flexibility given to the lender, at a slightly lower price than it would have
had to pay for a normal time deposit.
The minimum denomination can be 100 000USD, although the issue can be as large as 1
million USD. The maturities of CDs usually range from two weeks to one year.
Non-financial corporations usually purchase negotiable CDs. Though negotiable CD
denominations are typically too large for individual investors, they are sometimes
purchased by money market funds that have pooled individual investors’ funds. Thus
money market funds allow individuals to be indirect investors in negotiable CDs. This way
the negotiable CD market can be more active. There is also a secondary market for these
securities, however its liquidity is very low.
Concept Negotiable certificates of deposit are certificates that are
issued by large commercial banks and other depository
institutions as a short-term source of funds.
The negotiable CDs must be priced offering a premium above government securities (e.g.
Treasury bills) to compensate for less liquidity and safety. The premiums are generally
higher during the recessionary periods. The premiums reflect also the money market
participants’ understanding about the safety of the financial system.
Question What factors lead to rise / decline in certificates of deposit
market?

Negotiable CDs are priced on a yield basis. Institution issue negotiable CDs at a par value.
Thus the yield of the security is calculated:
y = ( PAR – P )/ P x (360 / n)
Example A three-month CD for 100 000 Euro at 6 per cent matures in
73 days. It is currently trading at 99 000 Euro. Rate of return
of this CD current offering is
y = (100 000 – 99 000 )/ 99 000 x (360 / 73) =
= 0,01 x 4,93 = 0,0493 or 4,93%

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The market price of the CD is found by discounting the par or maturity value by the rate of
interest currently available on similar assets, adjusted for the residual maturity.
The price of CDs is determined using the following equation:
P = PAR / (1 – (i x n / 360))
Question Find the price of a three-month 150,000 Euro CD, paying 4
per cent, if it has 36 days to maturity and short-term interest
rates are 4 per cent.
What will be the price of this same CD if short-term interest
rates fall to 2 percent?
The annualized yield they pay is the annualized interest rate on negotiable CDs. If
investors purchase and holds negotiable CDs until maturity, their annualized yield is the
interest rate. However, if investors purchase or negotiable CDs in the secondary market
instead of holding them from issuance to maturity, then annualized yield can differ from
the annualized interest rate.
y = (Selling Price – Purchase Price + Interest) / Purchase Price
Example An investor purchased a negotiable CD a year ago in a
secondary market. He redeems it today upon maturity and
receives 1 million Euro. He also receives 40000 Euro of
interest. What is investor’s annualized yield on this
investment?
The interest rate paid on CDs is often linked to interbank rate. If LIBOR is 4,75 per cent,
for example, the CD described above might be paying 5 percent because it is quoted as
paying LIBOR plus 25 basis points.
Certificates of deposit are an alternative of short-term, wholesale lending and borrowing.
Three- and six-month maturities are common. Some CDs are issued for one year and even
for two years but the market for these is comparatively thin. This has led to the practice of
banks issuing ‘roll-over’ CDs, i.e. six-month CDs with a guarantee of further renewal on
specified terms. CDs are issued by a wide variety of banks. It is quite common for a bank
both to have issued and to hold CDs, though normally of differing maturities. It will issue
CDs with a maturity expected to coincide with a liquidity surplus and hold CDs expected
to mature at a time of shortage.

3.2.5. Repurchase agreements

A repurchase agreement (REPO) is an agreement to buy any securities from a seller
with the agreement that they will be repurchased at some specified date and price in the
future.
Concept Repurchase agreement (REPO) is a fully collateralize loan
in wich the collateral consists of marketable securities.

In essence the REPO transaction represents a loan backed by securities. If the borrower
defaults on the loan, the lender has a claim on the securities. Most REPO transactions use
government securities, though some can involve such short-term securities as commercial
papers and negotiable Certificates of Deposit.

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Since the length of any repurchase agreement is short-term, a matter of months at most, it
is usually assumed as a form of short-term finance and therefore, logically, an alternative
to other money market transactions.
Concept Open REPO is a REPO agreement with no set maturity date,
but renewed each day upon agreement of both counterparties.

Concept Term REPO is a REPO with a maturity of more than one

day.

A reverse REPO transaction is a purchase of securities by one party from another with the
agreement to sell them. Thus a REPO and a reverse REPO can refer to the same
transaction but from different perspectives and is used to borrow securities and to lend
cash.
The participants of REPO transactions are banks, money market funds, non-financial
institutions. The transactions can amount 10 million in USD terms with the maturity from
one to 15 days and for one, three, six months. There is no secondary market for REPOs
Since the effect of the REPO transactions influence money market prices and yields, it is
normal to regard such REPOs as money market deals. In a REPO, the seller is the
equivalent of the borrower and the buyer is the lender. The repurchase price is higher than
the initial sale price, and the difference in price constitutes the return to the lender.
The amount of REPO loan is determined in the following way:
REPO principal = Securities market value x ( 1 – Haircut )
Securities market value = PAR x ( 1 – (d x n / 360 ))
where the securities market value is determined as the current market value of these
securities, d is the rate of discount of the securities, n is term of the securities, PAR is the
par value of the securities.
In the REPO transaction securities market value is equal to the value of collateral, against
which the borrowing takes place. Since the value of the securities may be fluctuating
during the term of , the amount of the loan (the principal) is less than the current market
value of the securities.
The deduction from current market value of the securities collateral required to do the
REPO transaction is made, which is call a haircut or a margin. The haircut is a margin
stated in terms of basis points. A standard haircut can be, e.g. 25 basis points (or
0,0025%). Thus a REPO loan is overcollateralized loan meaning that the amount of the
collateral exceeds the loan principal and the haircut.
Repurchase of the securities is made by repaying REPO loan and interest:
REPO principal + Interest = REPO principal ( 1 + (y x t / 360 ))
where y is the yield or rate of the REPO transaction, t is the term of the REPO transaction.
REPO principal = Securities market value x (1 – Haircut)
Securities market value is defined as present value of the par value of the securities
involved in the transaction.
Concept Haircut – the function of a broker/ dealer’s securities
portfolio, that cannot be traded, but instead must be held as
capital to act as a cushion against loss.

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The haircut or margin offers some protection to the lender in case the borrower goes
bankrupt or defaults for some other reason. The size of the risk, and thus this haircut /
margin, depends in large part upon the status of the borrower, but it also depends upon the
precise nature of the contract. Some REPO deals are genuine sales. In these circumstances,
the lender owns the securities and can sell them in the case of default. In some REPO
contracts, however, what is created is more strictly a collateralized loan with securities
acting as collateral while remaining in the legal ownership of the borrower. In the case of
default, the lender has only a general claim on the lender and so the haircut / margin is
likely to be greater.
Example Consider a 90 day REPO transaction, with a REPO rate of
4,75%. 180 days government securities with a rate of
discount of 5% and a par value of 10 million Euro are used as
collateral. Assume that the haircut is equal to 25 basis points.
What is the amount of REPO loan? What is the amount of
REPO loan repayment in the transaction?
REPO deals are quoted on a yield basis. The rate is quoted as a simple interest yield on a
360 days basis set upon initiation of the transaction and fixed for the term of REPO.
The REPO rate or yield is calculated:
y = ( PAR – P ) / P x (360 / t )
where P is the purchase price, PAR is the agreed repurchase price and t is the period of the
transaction.
Example Investor has purchased securities at a price of 9 980 000
Euro, with an agreement to sell them back at 10 million Euro.
At the end of 15 days period. What is the yield of the
transaction?
REPO transactions have two legs: 1) when cash is borrowed against collateral; 2) when
REPO transaction takes place, i.e. securities are repurchased by repaying REPO loan plus
interest.
The repurchase of the securities (REPO payment) is completely independent from the
market value of the securities on the maturity date of the REPO. This reinforces the
economic reality that REPO transaction is a collateralized loan.
In a reverse REPO transaction the reverse payment is calculated:
Reverse principal + Interest = Reverse principal x ( 1 + (y x t / 360))
where y is the yield or REPO rate, t is maturity of the reverse REPO.
Example Assume a financial institution utilizes a reverse REPO to
borrow securities and to lend cash. The securities collateral is
1 million of par value government securities paying 6% p.a.
semi annually with 5 years to maturity. A REPO rate is 4,5%,
181 day of maturity, with a 50 basis points of haircut. What is
the amount of reverse REPO repayment of the transaction?
REPO and reverse REPO markets as well as number of their participants have grown up
tremendously, especially due to increased sensitivity to interest rate risk and the
opportunity cost of holding idle cash.

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 Question What determines the size of the REPO principal? What
determines the size of the REPO repayment?

REPO transactions are negotiated through a telecommunications network. Dealers and

REPO brokers perform the role of financial intermediaries to create REPO transactions fro
the companies with funds deficit or excess funds, and receive a commission for such
services. However, direct REPO transaction is executed, when there is a possibility to find
counterparty for it.
Market participants include central banks, financial institutions, non-financial
corporations.
Central banks conduct short-term REPO transactions on bonds of any residual maturity as
a means of influencing money market interest rates. ‘
Non-financial companies, private financial institutions are more likely to utilize reverse
REPOs to earn interest on their cash balances during the periods of high interest rates.
Speculative REPO and reverse REPO transactions are attractive to financial institutions
with the increased volatility of interest rates. Money market funds often take the other side
of REPO transactions and hold reverses in their assets portfolios as flexible short-term
investment vehicles. Individuals, owning shares in these funds, earn interest on the
reverses. The fund managers may speculate on interest rate fluctuations using REPOs and
reverse REPOs without being subject to the limitations on speculative derivative
transactions. Important participants of the REPO market are security dealers. They make
markets by carrying inventories of marketable securities, and can use these securities as
collateral on REPO loans. Thus they can reduce the cost of financing, utile REPOs to take
positions on interest rates, finance their securities portfolios.
Interest yields for REPOs of different terms reflect a term structure of interest rates which
is a market consensus on forecasted interest rates. The REPO rate is significantly lower
than other money market rates, however higher than the rate of government securities. It is
maintained by possibility to substitute different money market instruments. There is no
REPO secondary market.

3.2.6. International money market securities

Apart from variety of money market instruments which enable short-term lending and
borrowing to take place in the domestic currency, in recent years some of the fastest
growing markets have been the so-called eurocurrency markets. These are markets in
which the borrowing and lending denominated in a currency of some other country takes
place. In general, eurocurrency market instruments are the same as other money market
instruments. When such instruments are denominated in some other currency, they are
identified as ‘euro-’, though it can be any currency (e.g. US dollars, or Japanese yen). The
trading can also take place anywhere (in European countries or in New York or Tokyo or
Hong Kong).
Concept Eurocurrency instrument is any instrument denominated in
a currency which differs from that of the country in which it
is traded.
The factor contributing to the long-term development of eurocurrency business was the
ability of eurobanks to offer their services at more competitive rates than domestic
institutions. ‘Eurobanks’ are banks which specialize in eurocurrency business. They
channel funds between surplus and deficit units and, and thus create assets and liabilities

49
which are more attractive to end-users than if they dealt directly with each other, also they
help to use funds which might otherwise lay idle.
In the Eurodollar market banks channel the deposited funds to other companies which
need to receive Eurodollar loans. The deposit and loan transactions are of large
denominations, e.g. exceeding 1 million USD. Therefore only governments and largest
corporations can participate in the market. The market growth was influenced greatly by
Eurocurrency liabilities of financial institutions are the following:
 Euro Certificates of deposits
 Interbank placements
 Time deposits
 Call money
Euro certificates of deposits (Euro CDs) are negotiable deposits with a fixed time to
maturity.
Time deposits are non negotiable deposits with a fixed time to maturity. Due to illiquidity
their yields tend to be higher than the yields on equivalent maturity of negotiable Euro
certificates of deposits.
Interbank placements are short-term, often overnight, interbank loans of Eurocurrency
time deposits.
Call money are non negotiable deposits with a fixed maturity that can be withdrawn at any
time.
Eurocurrency assets of financial institutions are the following:
 Euro Commercial Papers (Euro CPs)
 Syndicated Euroloans
 Euronotes
Euro Commercial Papers (Euro CPs) are securitized short-term bearer notes issued by a
large well-known corporation. They are issued only by private corporations in short
maturities with the aim to provide short-term investments with a broad currency choice for
international investors. Most issues are pure discount zero coupon debt securities with
maturities from 7 to 365 days. Issuance may be conducted through an appointed panel of
dealers.It can be resold in a highly liquid secondary market. The issuers should be highly
rated as Euro CPs are unsecured.
Syndicated Euroloans are related to bank lending of Eurocurrency deposits to non-
financial companies with the need for funds. Since they are non-negotiable, banks used to
hold the syndicated loans in their portfolios until they mature. Due to their illiquidity, the
loans are often made jointly by a group of lending banks, which is called a syndicate. The
role of syndication is to share loan risks among the banks that members of the syndicate.
Euronotes are unsecuritized debt instruments, substitutes for non-negotiable Euroloans.
They are short –term, most often up to one year. Floating rate notes (FRNs) offer a
variable interest rate that is reset periodically, usually seminannually or quarterly,
according to some predetermined market interest rate (e.g. LIBOR). For a high rated issuer
the interest rate can be set lower than LIBOR.

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 3.3. Money market interest rates and yields
Short-term money market instruments have different interest rate and yield quoting
conventions. The yield on short-term money market instruments is often calculated using
simple interest as opposed to compound interest, and as a result is not directly comparable
with the yields to maturity.
Short-term government securities (Treasury bills), commercial papers are often quoted and
traded on a ‘discount’ basis, while interbank loan rates, REPO rates are quoted on an “add-
on” basis.
Besides, it is a convention in the US Treasury bills market to assume that a year has 360
days, while if it is denominated in sterling it has 365 days, even in a leap year. Short-term
money market instruments frequently do not have a specified coupon and as a result
investors in them obtain a return by buying them at a discount to their par or maturity
value.
Below is provide the comparison of different money market rates and yields.

1) Rate on a discount basis

d = ( PAR – P ) / PAR x (360 / t )
where d is the yield on the basis of rate of discount, PAR – par value, P – the purchase
price of the security and t is the number of days until maturity.
Discount is calculated in this case as a percent from par value. It also assumes a 360 days
year.
Example A 90 day US dollar Treasury bill is issued at 99% of its par
value. It will be redeemed at its par value (100 %) 90 days
after issue. It is traded on a discount basis. The discount of
this issue is:
d = (100 − 99) / 100 × 360 / 90 = 4%
Note that in the US dollar money market a year is assumed to
have 360 days.
The discount is often converted into a yield so as to make it comparable with other money
market instruments. This yield is often called a ‘money market yield’. Using the above
example, the money market yield is just 4 × 100/99 = 4.0404 %.

2) Add-on rate
y = ( PAR – P ) / P x (360 / t )
where y is the yield on the basis of add-on rate, PAR – par value, P - the purchase price of
the security and t is the number of days until maturity.
Example Assume 990 000 Euro is lent for a 90 day period at the add-
on rate. The par value is 1000 000 Euro.
The annualized yield of the security at an add-on basis will be
y = (1000000 – 990000) / 990000 ) x ( 360 / 90 ) =
= 0,0404 or 4,04 %.

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 3) Bond-equivalent yield
y = ( PAR – P ) / P x (365 / t )
where y is the yield, PAR – par value, P - the purchase price of the security and t is the
number of days until maturity.
Example Assume the same 90 day US dollar Treasury bill issued at
99% of its par value. It will be redeemed at its par value (100
%) 90 days after issue. The bond equivalent yield this issue
is:
y = (100 − 99) / 99 × 365 / 90 = 4, 097%
The bond equivalent yield is used to compare Treasury bill yields with the yields to
maturity of coupon bearing Treasury notes and bonds. The bond equivalent yield is is an
approximation of the yield to maturity of a bond.
The bond equivalent yield is higher than the discount rate. The difference is larger for
longer maturities and for higher levels of discount rate d. Therefore an error of yield using
discount rate d increases for longer maturities and for higher rates.

4) Annual yield to maturity

y = ( PAR / P ) (365 / t ) – 1
where y is the yield, PAR – par or maturity value, P - the purchase price of the security
and t is the number of days until maturity.
Example Assume the same 90 day US dollar Treasury bill issued at
99% of its par value. It will be redeemed at its par value (100
%) 90 days after issue.
Annual yield to maturity of this money market instrument is:
y = ( 100 / 99) (365 / 90) - 1 = 4, 097%

5) Semiannual yield to maturity

y = 2 x ( PAR / P ) (365 /2 t ) – 2
where y is the yield on the basis of add-on rate, PAR – par or maturity value, P - the
purchase price of the security and t is the number of days until maturity.
Example Assume the same 90 day US dollar Treasury bill issued at
99% of its par value. It will be redeemed at its par value (100
%) 90 days after issue.
The semiannual yield to maturity of this money market
instrument is:
y = 2 x ( 100 / 99) (365 /2x 90) - 2 = 4, 097%
Comparison of all the money markets rates and yields are provided in Figure 9.
It shows that the largest is always the annual yield, which is then followed by semiannual
yield, bond equivalent yield, the yield on the basis of add-on rate and the yield on discount
basis. The difference between bond equivalent yield and the semiannual yield are smaller
for longer maturities and approach as the maturity approaches half a year. The longer the
maturity, the smaller is the difference between bond equivalent yield and the annual yield.

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Finally, the longer the maturity, the larger are the differences between the money market
discount rate and other rates.

Rate

Semiannual

Annual Bond equivalent yield

Add-on rate

Discount rate

Days
90 180

Figure 9. Money market rates and yields

Several specific money market interest rates are used in Europe.
The key European Central Bank (ECB) interest rate is the minimum bid rate, which
represents the price floor, which ensures central bank liquidity in the open-market
operations. The two other key interest rates, on the marginal lending facility and the
deposit facility, define the corridor within which the overnight interest rate can fluctuate.
The Governing Council of the ECB sets the level of the minimum bid rate in the
Eurosystem’s weekly main refinancing operations (MROs). Through the MROs, the ECB
aims to supply the liquidity necessary for the banking system to operate smoothly. This
way very short-term money market interest rates are aligned with the monetary policy of
the ECB. Through the money-market yield curve, monetary policy is transmitted to
financial instruments and credit conditions more generally, which in turn will influence
saving and investment decisions and thus will affect price developments in the euro area.
When money market is affected by crisis in the financial markets, the ECB needs to
provide additional liquidity in order to support market confidence.
Apart from the ECB interest rates, there are other main market interest rates for the money
market:
 EONIA (euro overnight index average). The EONIA is the effective overnight
reference rate for the euro. It is computed daily as a volume-weighted average of
unsecured euro overnight lending transactions in the interbank market, as reported
by a representative panel of large banks.
 EURIBOR (euro interbank offered rate). The EURIBOR is the benchmark rate
of the large unsecured euro money market for maturities longer than overnight (one
week to one year) that has emerged since 1999. It is based on information provided
by the same panel of banks.

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  EUREPO (the REPO market reference rate for the euro) for different maturities.
The EUREPO is the benchmark rate of the euro REPO market and has been
released since March 2002. It is the rate at which one prime bank offers funds in
euros to another prime bank when the funds are secured by a REPO transaction
using general collateral.
 The rate of interest paid on interbank loans in London (UK) is known as London
InterBank Offer Rate or LIBOR. It is an important reference to banks of the cost
of raising immediate marginal funds. Numerous bank interest rates are therefore
tied to LIBOR, particularly to the rate for three-month deposits.
The spreads among the key ECB interest rates and short-term market interest rates are low.
E.g., EONIA is mostly slightly above, but very close to, the minimum bid rate. The small
spread (about 6 to 7 basis points) reflects that the EONIA is an unsecured interbank rate. It
includes a small premium for credit risk and transaction costs. Larger spreads normally
occur at the end of the reserve maintenance period when there is a need for the banks to
fulfil the reserve requirement.
The yields of money market securities are closely monitored by money market
participants. Since money market securities are seen as close substitutes, investors may
exchange them to achieve more attractive yields. This causes yields among the securities
to come closer. If there is a difference between yields, investors will avoid lower yielding
instruments and will favour the ones with high-yield. During the periods of larger
uncertainty about the economy, investors tend to shift from more risky money market
securities to Treasury bills and other government securities.

3.4. Summary
Money market securities short-term instruments, which have maturities shorter than one
year. Trading with these securities in interbank, primary and secondary markets are very
active. The volume of transactions in national markets as well as international markets is
large. A variety of money market securities allow to meet special needs of borrowers and
lenders.

Key terms
 Money market
 Commercial paper
 Certificate of deposit
 REPO
 Treasury bills
 Interbank market

Further readings
1. Bernanke B., Blinder A. (1992). The FF rate and the channels of monetary
transmission, Journal of Banking and Finance, No. 16, p. 585-623.
2. European Central Bank (2007). Euro Money Market Survey, ECB, Frankfurt am
Main.

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